Enron’s reported earnings on common stock were $788 million for the first 6 months of 2001 (compared to $58 million for 2000). For the quarter ending 30 June 2001, earnings were $383 million (compared to $268 million for 2000). Up to 30 June 2001, Enron was doing well based on the published financial statements.
The long-term debt was $9355 million as of 30 June 2001, up from
$8530 million as of 31 December 2000. The stockholder equity was
$11,740 million, up from $11,470.
The cash flow from operating activities was a negative $1337 million for the 6 months ending 30 June 2001. The primary item causing the negative cash flow was $2342 million use of cash for net margin deposit activity (this was the repayment of loans). Excluding net margin deposit activity, cash provided by operations was a positive
$1005 (p. 31).
Capital expenditures were $1200 million up from $1009. Equity investments were $1088 million up from $390 million. These were bullish indicators.
The dividends paid were $256 million down from $265 million.
This reflects the changes in the amount of outstanding preferred and common shares, and is not significant.
∗All the page references in this chapter are to the 10Q of 14 August 2001 or the Skilling–Lay trial proceedings unless otherwise indicated.
31
The repurchase of common stock was $209 million compared to
$129 million for the first 6 months of 2000. The increase in shares repurchased might be mistakenly interpreted to be a slight bullish signal. It is more likely to be the repurchase of shares from the management.
Net cash paid for income taxes was $167 million in the first six months of 2001 and $33 million for 2000. This reflects an increase in taxable income.
In March 2001, Enron paid $330 million for 39 million shares of Azurix common stock. Increasing its ownership of Azurix implies that the initial investment was thought to be desirable and Enron was increasing its investment in that subsidiary. This transaction in 2001 was important since during the Skilling–Lay trial the Gov- ernment would argue that both Skilling and Lay knew that the Azurix investment was overvalued. For example, the closing argu- ment of Ms K. H. Ruemmler quotes Ben Glisan (p. 17818), the Enron Treasurer:
And third, we knew that as a result of Raptor, but also other areas, inclusive of Broadband and Azurix, that there were charges that should be taken. So the request that was made of me by Mr. Whalley and Lay was “How much could we take without losing our credit rating?”
The point being made seemed to be that more of the Azurix invest- ment should be written off as an expense. But an additional investment in Azurix was made in March 2001 because it is estimated that the net present value of the benefits exceeded the cost of the new invest- ment. Enron management was bullish on Azurix. Maybe they were incorrect, but being incorrect is not a crime.
Ms Ruemmler gives a reason for not taking a goodwill loss (p. 17820):
A final decision has been made that we are not willing to take any goodwill impairment on Wessex.
Who made that final decision? Mr. Lay made it. How do you know? You know it because Mr. Glisan told you
that they had a discussion that they couldn’t take any more than a billion dollars. They could not afford to take the
$700 million Wessex goodwill loss that they needed to take, so they had to come up with a scheme to avoid that.
The most powerful motive in the world to come up with a scheme to defraud Arthur Andersen is if you know that if you take a bigger loss, that it’s going to mean certain death for the company because a credit downgrade will ensue.
She states (p. 17820), “that there was a $1 billion value problem, potential loss, in Azurix”. But a potential loss is not a valid reason for writing down an asset or to accuse a manager of a crime because the write-down was not made. Any accounting value of an asset is a potential loss.
Continuing (p. 17821), Ms Ruemmler goes on:
One, did Enron tell AA that there was a water growth strategy to avoid a goodwill impairment?
Of course, a firm does not need growth to avoid a goodwill impair- ment. This line of irrelevant argument goes on for several pages.
Sean Berkowitz (US Attorney), in his closing argument, also makes the point that Enron did not have a growth strategy. He does not argue that Azurix and Wessex (an asset of Azurix) did not have value (p. 18297).
The way that they avoided a goodwill write-down in the third quarter was by lying to Arthur Andersen. There’s no question, no question, ladies and gentlemen, that Enron was telling Arthur Andersen that it had a growth strategy for Wessex. No question.
If Enron had a growth strategy for Azurix, it would not prove that the Azurix asset cost did not exceed its value (thus should be written down). Also, even if Enron did not have a growth strategy for Azurix, it would not prove that it should therefore be written down.
In summary, the existence or lack of a growth strategy for Azurix was
not an indication of the value of the asset’s cash flows compared to the asset’s cost.
In March 2001, Enron acquired the limited partner’s equity on the unconsolidated equity affiliate Joint Energy Development Investments Limited Partnership (JEDI) for $35 million. This acquisition leads to JEDI now having to be consolidated (later we shall learn that JEDI should have been consolidated since 1997). JEDI owns an investment of 12 million shares of Enron common stock valued at $785 million and other assets of $670 million. JEDI had debts of $950 million of which $620 million was third-party debt and $330 million was owed to Enron. Chapter 7 explores JEDI in more detail.
Dabhol Power Company
Enron owns 65% of the economic interest in Dabhol Power Company (India) which owns a 740 MW power plant and was expanding the plant to a 2184 MW power capacity and was building a LNG regasi- fication facility in conjunction with the power plant. General Electric and Bechtal Corporation each owned 10%. Dabhol’s customer, the Maharastra state utility owned 15%.
The debt of Dabhol is non-recourse to Enron (Enron is not liable for Dabhol’s debt).
There was a dispute between the Dabhol investors and various Indian authorities (the Electricity Board, the state government, and the federal government of India). “As a result of these disputes, the 740 MW power plant is not being dispatched…. Further, Dabhol has suspended construction activity on Phase II” (p. 10). There is a major disagreement about the amount that should be paid to Enron and its fellow capital contributors. The buyer of the electricity claimed that it was being overcharged. The outlook for Enron’s Indian investment is not sanguine, but it is not hopeless.
Despite those difficulties “Enron does not believe that any con- tract dispute related to Dabhol will have a material adverse impact on Enron’s financial condition or results of operations”. This is a very nạve conclusion. Enron has almost a $2 billion investment in India at risk. The total cost of the plant exceeded $2.9 billion.
On 21 May 2001,The New York Timeson page 1 had a heading
“Electricity Crisis Hobbles an India Eager to Ascend”. The article stressed the economic advances made by India but pointed out that
“an electricity crisis represents one of the major hurdles to India’s ability to hoist itself into the front ranks of the global economy”.
The Dabhol Power Company may belatedly turn out to be a sensible investment.
Business Segment Information
For the 6 months ending 30 June 2001, the following incomes were reported by segment:
Income (loss) before interest, minority interests, and
income taxes
Wholesale services $1557 million
Retail energy services $100 million
Broadband services $(137) million
Transportation and distribution $335 million
Note that a large loss for Broadband ($137 million) was reported.
The Government will argue that excessively optimistic reports were given relative to Broadband.
Except for Broadband, all the business segments reported profitable operations. Wholesale services and retail energy services had improved results compared to year 2000.
The Trial: Broadband
Enron’s 10Q report of 14 August 2001 showed a loss for Broadband services of $137 million. Ms Ruemmler focuses on
Skilling’s statements rather than the reported results of operations (p. 17742):
For the benefit of the stock, Mr. Skilling lied about the revenues of the business, and Mr. Skilling failed to fully disclose the business failure to the public.
And later she states (p. 17746):
They’re trying to leave the impression that this business is succeeding. It’s gaining traction. It’s actually going to be profitable in the future. No question it was a startup, no questions they were only going to be posting losses;
but they needed to show that they were generating some revenue.
In order to limit Broadband’s reported loss, a decision is made to cut expenses (p. 17748):
At this meeting, there’s a decision made to drastically cut expenses, to reduce head count, because they have to pro- tect the number that has been given to The Street, the $65 million loss number.
The agreement coming out of that meeting, Mr. Rice and Mr. Hannon told you, was to keep the loss target at
$65 million and to drastically cut costs.
Ms Ruemmler could have added that reducing expenses may be a reasonable way of reducing an expected loss. Instead, the opportunity is taken to imply that lies are being told to misstate the amount of loss. Maybe lies were told but it should not be implied that cost reduc- tion implies the existence of a crime. Also, a $137 million Broadband Services loss was reported for the six months ending 30 June 2001.
Derivatives
“Derivative contracts are entered into with counterparties who are equivalent to investment grade” (p. 14). This statement is important since the failure of Enron to maintain an investment grade rating accelerated its slide down the slope to bankruptcy.
Related Party Transactions
A senior officer of Enron (Andrew Fastow) was the general partner of the related party partnerships. He sold all his financial interests in the related parties as of 31 July 2001, and after that date he no longer had any management responsibilities for these entities. The partnerships were no longer related to Enron. But the damage had been done.
“All transactions with these partnerships (the Partnerships) have been approved by Enron’s senior risk officers as well as reviewed annually by the Board of Directors” (p. 15). It is not obvious that this statement is exactly true. We shall review this later in more detail.
In 2000, Enron committed to deliver to a related party 12 mil- lion shares of Enron common stock in 2005. Enron “entered into derivative instruments” (p. 15) “that eliminated the contingent nature of existing restricted forward contracts executed in 2000”. Since the report does not define the nature of the derivative instruments, we cannot analyze the nature and function of these transactions.
In exchange for its common stock Enron received $827.6 million of notes receivable. If the related party is not “independent” of Enron the $827.6 million should not be recorded as an asset by Enron and there should not be an increase in stock equity.
Real Volumes
It is not easy to forget that Enron was a real corporation dealing with real things. For example, Enron’s sales of gas were 24,554 billion of British thermal units in the first 6 months of 2000 and increased to 34,427 in 2001 (p. 25). Crude oil and liquids sales increased by 51%
is the period 2000–2001. Total electricity volumes increased by 110%
(p. 25).
The revenues from retail energy services increased from $734 mil- lion in 2000 to $1250 million in 2001. Income before interest, minor- ity interests, and taxes, increased by 92% (p. 26).
Financial Condition
Management anticipates cash from operating activities in the second half of 2001 to be positively impacted by
reduced working capital requirements and overall operat- ing activities (p 31).
Return on Revenue
The revenues for the first six months of 2001 were $100,189 million and income before interest, minority interests, and income taxes, was
$1588 million. The return per dollar of revenue was 100,1891588 =0.016, down from 0.025 for the year 2000. It was becoming more difficult for Enron to make profits from a dollar of revenue.
Return on Equity
The earnings on common stock for the first six months of 2001 were
$788 million and the shareholders’ equity was $11,740 million. The return on stock equity was 11,740788 = 0.067 for 6 months or a 0.134 equivalent return for the year. This was better than the returns earned for 1998–2000, but it is not a great return.
Conclusions
Enron’s 10Q of 14 August 2001 submitted to the SEC is a collection of good news. Based on published information, Enron had excellent performance in the first six months of 2001, and its financial condition was healthy.
Jeffrey Skilling claims that he resigned as CEO in August 2001 when the financial situation of Enron was good. If all he did was read the 10Q submitted on 14 August 2001, he had reason to be sanguine.
The Editorial of the 18 January 2002 issue of The Wall Street Journalincludes the following:
The culture wanted to believe in Enron’s promises, which helps explain why 16 of 17 Wall Street analysts rated Enron a “buy” as recently as last October.
The Senate Governmental Affairs Committee found that 10 of 15 security analysts reporting on Enron rated the stock as a “buy” or a
“strong buy” as of 8 November 2001. Rather than concluding that the recommendations were based on the low Enron stock price, Senator Joseph Lieberman attributed the bad investment advice (ex post) to a conflict of interests (the selling of investment banking services):
No matter what the market does, analysts just seem to keep saying “buy” (Wall Street Journal, 28 February 2002, p. A1).
We can add that the published financial statement (filed on 14 August 2001) reported reasonable operating results for the first 6 months of 2001. In evaluating decisions that were made prior to 16 October 2001 we should be careful to consider only the information that was available to the public during that time period.
Would different accounting standards and practices have led to a different bankruptcy date for Enron? Different accounting practices would have affected the timing of its bankruptcy. Its stock price is likely to have declined at an earlier date since the reported incomes would have been much reduced. The panic might have started earlier.
With less opaque accounting and fewer accounting errors it is pos- sible that Enron would not have entered bankruptcy. But its stock price would not have reached the peaks it reached in 2000. If Enron had followed different accounting practices (less optimistic), the gains made by investors prior to August 2001 would have been less and if the accounting incomes during 1998–2001 had been lowered, some of the losses would have been suffered by other investors. But losses would have taken place. When a stock is too high, someone has to lose.
The Government claims that Skilling and Lay lied about Enron’s financial health before 1 July 2001, and that there were signs of weak- ness (e.g., Broadband and Enron Energy Services). But neither Skilling nor Lay acted on this information by selling the majority of their stockholdings and it is more likely that they believed that Enron was a healthy corporation from a financial viewpoint.